A Rigged Stock Market: The Fed, Debt, & Buybacks | Part 2

So what is “buying on margin?”

Buying on margin is a way to use debt to amplify one’s gains; however, the problem with borrowing money to buy stocks, is it will also amplify the losses. Due to record low interest rates brought on by the Fed, there has been a huge influx of corporations and speculators borrowing on margin to buy stocks. The problem that stems from this excessive use of leverage, is when a downturn does occur, and prices start to fall quickly, this will induce margin calls, which will then trigger more selling, which leads to an extreme rapid decline in stock prices. And right now, we are seeing historical numbers on the use of debt, which similarly was seen at the last major bubbles (the tech and housing), and the crash before the Great Depression.

As Lance Roberts of Clarity Financial has pointed out:

“Over the last 12 months, US corporations have added a massive $517 billion in new debt to their balance sheets, which is the second highest level ever.”

As you can see in the chart below, although there has been continued growth in cash held by companies over the last ten years, which is a good thing; a lot of it is held overseas for tax reasons and is not easily available to pay down debt if a problem does arise. Moreover, masking the increase in cash, has been the growth in debt levels, which are markedly higher, making the “cash as a percent of debt” getting to numbers we haven’t seen since 2007. This poses a problem. If a market drop does happen, and corporations have remained highly leveraged with access to cash difficult or limited, it could be like pouring gasoline on a fire.

As reported by Factset:

“As the cash balance for companies in the S&P 500 (Ex-Financials) index continued to grow, the debt amount has done the same. In fact, aggregate debt has grown at a faster clip than cash and short-term investments. Total debt for the index increased 7.6% year-over-year, reaching its largest level in at least ten years. Looking at the YOY average growth rate going back three years, growth in debt has increased at pace 1.7 times faster than the growth in cash and short-term investments. One of the uses that companies have for this debt is to repurchase shares and pay out dividends. Shareholder distributions had been near record levels for the past four quarters before the sharp decline in Q2.”

What is all this debt being used or?

There is a direct correlation between the elevated levels of debt and the soaring rise in stock prices. With corporations having access to cheap borrowing costs, and with nominal economic growth being so weak, these revenue starved companies have been binging on debt to buy back shares to boost their own bottom line earnings. Instead of actual organic growth, it is artificial, nothing more than neat tricks of moving money around; with an ultimate end goal of enriching big business management and executives via stock option based compensation plans.

What are buybacks?

It’s when a company buys back stock. In short, there are fewer shares for investors to buy (supply and demand) which increases the price of the outstanding shares, increasing the profits per share calculation.

“It’s official, using proceeds from debt sales to send cash to stockholders has never been more popular.”

Dr. John Hussman addressed the same issue:

“The larger problem with repurchases is that debt-financed buybacks effectively put investors on margin. As corporations have borrowed in order to aggressively buy back their stock near the highest market valuations in history, existing stockholders have quietly become heavily leveraged, without even realizing it.”

“So not only is the equity market at the second most overvalued point in U.S. history, it is also more leveraged against probable long-term corporate cash flows than at any previous point in history. As we observed during the housing bubble, yield-seeking by investors opens the door to every form of malinvestment. The best way to create a debt-financed wave of speculative and unproductive activity is to starve investors of safe return. In 2000 that wave of speculation focused on technology. The next Fed-induced wave of speculation focused on mortgage securities, which financed a housing bubble. In our view, the primary avenue of speculation in the current cycle has been debt-financed corporate equity purchases.”

According to FactSet on the record number of buybacks:

“Companies in the S&P 500 spent $166.3 billion on share buybacks during the first quarter, which marked a new post-recession high. Since 2005, only Q3 2007 produced a larger amount of buybacks ($178.5 billion). Dollar-value buybacks in Q1 represented a 15.1% increase in spending from the year-ago quarter, and a 15.6% jump from Q4. This breakout in the first quarter of the year comes amid somewhat of a stabilization period for buybacks since the middle of 2014. With that said, buyback spending still remained at very high levels for the index during this period.”

The recent growth of the stock market has been nothing but financial manipulation, sparked by the actions of the Fed, followed through by corporations having availability of cheap speculative capital, and then buying back their own stock painting an illusion of profitability and growth. If you caught the wave at the beginning, you benefited, but the ride will soon come to an end, as all do.